Stephen Bainbridge's Journal of Law, Religion, Politics, and Culture

10/18/2017

The Law and Economics of the “Special” Problem of Corporate Philanthropy

I've been kicking around corporate philanthropy with a friend and fellow corporate law academic. For what it's worth, I think I offer a pretty good summary of the state of the law in my book on Corporate Law:

The law’s basic position on corporate social responsibility [—the broader doctrine of which the question of corporate philanthropy is a subset—] famously was articulated in Dodge v. Ford Motor Co.[1] In 1916, Henry Ford owned 58% of the stock of Ford Motor Co. The Dodge brothers owned 10%. The remainder was owned by five other individuals. Beginning in 1908, Ford Motor paid a regular annual dividend of $1.2 million. Between 1911 and 1915 Ford Motor also regularly paid huge “special dividends,” totaling over $40 million. In 1916, Henry Ford announced that the company would stop paying special dividends. Instead, the firm’s financial resources would be devoted to expanding its business. Ford also continued the company’s policy of lowering prices, while improving quality. The Dodge brothers sued, asking the court to order Ford Motor to resume paying the special dividends and to enjoin the proposed expansion of the firm’s operations. At trial, Ford testified to his belief that the company made too much money and had an obligation to benefit the public and the firm’s workers and customers.

A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.

Consequently, “it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others.”

Despite its strong rhetoric, Dodge does not stand for the proposition that directors will be held liable for considering the social consequences of corporate actions. To be sure, having found that Ford had failed to pursue shareholder wealth maximization, the court ordered Ford Motor to resume paying its substantial special dividends. Invoking the business judgment rule, however, the Dodge court declined to interfere with Ford’s plans for expansion and dismissed the bulk of plaintiff’s complaint. The shareholder wealth maximization norm set forth in Dodge thus can be understood as a standard of conduct, while the business judgment rule remains the standard of review. Consequently, Dodge does not stand for the proposition that courts will closely supervise the conduct of corporate directors to ensure that every decision maximizes shareholder wealth. As the court’s refusal to enjoin Ford Motor’s proposed expansion illustrates, courts generally will not substitute their judgment for that of the board of directors. If a proposed course of action plausibly relates to long-term shareholder wealth maximization, courts will not intervene. Ford’s proposed expansion plans did so, and thus were allowed to go forward. Ford’s refusal to pay a special dividend, while simultaneously lowering prices, compounded by his anti-profitmaking trial testimony, did not. Accordingly, the court ordered him to pay the requested dividend. As always, authority and accountability are in tension. We have consistently argued that, absent self-dealing or other unusual circumstances, authority should prevail. Ford’s conduct lay at the outer boundary of defensible exercises of authority and the court appropriately slapped his wrist.

As the law evolved, corporate altruism began to be seen as proper so long as it was likely to provide direct benefits to the corporation and its shareholders. Applying the business judgment rule, moreover, many courts essentially presumed that an altruistic decision was in the corporation’s best interests. Shlensky v. Wrigley[2] exemplifies this approach. Recall that Shlensky, a minority shareholder in the Chicago Cubs, challenged the decision by Wrigley, the majority shareholder, not to install lights at Wrigley Field. Shlensky claimed the Cubs were persistent money losers, which he attributed to poor home attendance, which in turn he attributed to the board’s refusal to install lights and play night baseball. According to Shlensky, Wrigley was indifferent to the effect of his continued intransigence on the team’s finances. Instead, Shlensky argued, Wrigley was motivated by his beliefs that baseball was a day-time sport and that night baseball might have a deteriorating effect on the neighborhood surrounding Wrigley Field.

Despite Shlensky’s apparently uncontested evidence that Wrigley was more concerned with interests other than those of the shareholders, the court did not even allow him to get up to bat. Instead, the court presumed that Wrigley’s decision was in the firm’s best interests. Indeed, the court basically invented reasons why a director might have made an honest decision against night baseball. The court opined, for example, “the effect on the surrounding neighborhood might well be considered by a director.” Again, the court said: “the long run interest” of the firm “might demand” protection of the neighborhood. Accordingly, Shlensky’s case was dismissed for failure to state a claim upon which relief could be granted.

The rhetorical emphasis shifted significantly between Dodge and Shlensky. Where Dodge emphasized the directors’ duty to maximize profits, Shlensky emphasized the directors’ authority and discretion. Ultimately, however, they are consistent. The Illinois Appellate Court did not reject the profit-maximizing norm laid down by Dodge, but rather followed Dodge in holding that the business judgment rule immunized the directors’ decision from judicial review.

To be sure, a few cases posit that directors need not treat shareholder wealth maximization as their sole guiding star. A. P. Smith Manufacturing Co. v. Barlow, the most frequently cited example, upheld a corporate charitable donation on the ground, inter alia, that “modern conditions require that corporations acknowledge and discharge social as well as private responsibilities as members of the communities within which they operate.”[3] Ultimately, however, the differences between Barlow and Dodge have little more than symbolic import. As the Barlow court recognized, shareholders’ long-run interests are often served by decisions (such as charitable giving) that appear harmful in the short-run. Because the court acknowledged that the challenged contribution thus could be justified on profit-maximizing grounds, its broader language on corporate social responsibility is arguably mere dictum.

In any event, Dodge’s theory of shareholder wealth maximization has been widely accepted by courts over an extended period of time. Almost three quarters of a century after Dodge, the Delaware chancery court similarly opined: “It is the obligation of directors to attempt, within the law, to maximize the long-run interests of the corporation’s stockholders.”[4]

*****

As we have just seen, A. P. Smith Manufacturing Co. v. Barlow,[5] is often cited as a leading corporate social responsibility decision. Ironically, however, the specific question presented therein—the validity of corporate philanthropy—has been resolved in a more narrow way. Corporate charitable donations are subject to attack under two doctrines: ultra vires and breach of fiduciary duty. Neither is likely to succeed, so long as the amount in question is reasonable and some plausible corporate purpose may be asserted.

Virtually all states have adopted statutes specifically granting corporations the power to make charitable donations,[6] which eliminates the ultra vires issue. Although these statutes typically contain no express limit on the size of permissible gifts, courts interpreting the statutes require corporate charitable donations to be reasonable both as to the amount and the purpose for which they are given.[7] The federal corporate income tax code’s limits on the deductibility of corporate charitable giving are often used by analogy by courts seeking guidance on whether a gift was reasonable in amount.

As for breach of fiduciary duty claims, the principles announced in Dodge v. Ford Motor Co.[8] arguably require that corporate philanthropy redound to the corporation’s benefit. As Shlensky v. Wrigley[9] suggests, however, reasonable corporate donations should be protected by the business judgment rule.[10] Consequently, Barlow’s discourse on corporate social responsibility properly is regarded as mere dicta.

Law professors worry a lot about corporate philanthropy—a small forest has died to print all the law review articles on the subject.[11] Yet, the corporate law rules governing this subject are perfectly consistent with our theory of the firm. To be sure, corporate philanthropy poses a classic agency cost problem. Just as corporate managers may divert resources to perquisites for themselves, they likewise may divert resources to philanthropic giving from which they derive psychic utility. This suspicion is confirmed by Warren Buffet’s amusing anecdote:

I have a friend who is the chief fundraiser for a philanthropy. . . . All he wants is to take some other big shot with him who will sort of nod affirmatively while he meets with the CEO. He has found that what many big shots love is what I call elephant bumping. I mean they like to go to the places where other elephants are, because it reaffirms the fact when they look around the room and they see all these other elephants that they must be an elephant too, or why would they be there? . . . So my friend always takes an elephant with him when he goes to call on another elephant. And the soliciting elephant, as my friend goes through his little pitch, nods and the receiving elephant listens attentively, and as long as the visiting elephant is appropriately large, my friend gets his money. And it’s rather interesting, in the last five years he’s raised about 8 million dollars. He’s raised it from 60 corporations. It almost never fails if he has the right elephant. And in the process of raising this 8 million dollars from 60 corporations from people who nod and say it’s a marvelous idea, it’s pro-social, etc., not one CEO has reached in his pocket and pulled out 10 bucks of his own to give to this marvelous charity. They’ve given 8 million dollars collectively of other people’s money.[12]

The identities of the typical beneficiaries of corporate philanthropy likewise confirm that it is driven more by managerial ego than corporate advantage. The charities supported by most corporations tend to be rich people’s charities: art, music, public television, and the like. One can but question how big a bang a company gets for its advertising buck in giving to those charities.

One can concede the agency cost story, however, without conceding that the legal system ought to regulate corporate charitable giving. In the first place, it seems unlikely that corporate charitable giving even remotely approaches a level that materially injures shareholders. Although estimates vary widely, it seems unlikely that corporate charitable giving amounts to more than a couple of billion dollars annually, an infinitesimally small portion of total corporate earnings.

As noted, corporate charitable giving typically is defended on grounds that it produces good will and favorable publicity. In effect, charitable giving is simply another form of advertising. As such, it supposedly results in more business and higher profits. Who knows for sure if that is true? Maybe GM really does sell more luxury sport utility vehicles because it sponsors PBS programs—or maybe not. But that is not the right question. The right question is: who decides? The board of directors or the courts? That directors feel good about themselves for having made such a decision hardly seems like the kind of self-dealing that justifies heightened scrutiny.

Board discretion over issues like charitable giving is the inescapable side-effect of separating ownership and control. If there are good reasons for maintaining that separation, and there are, the board’s discretionary authority must be preserved. As we have repeatedly seen, holding directors accountable for their use of that discretionary authority inevitably limits that discretion. Consequently, deference to board decisions is always the appropriate null hypothesis.

There are cases where the board’s abuse of its discretionary authority warrants regulatory or judicial intervention. Breaches of the duty of loyalty spring to mind as the clearest example. As already noted, it seems doubtful that corporate philanthropy poses the sort of conflict of interest necessary to justify limiting board discretion. Yet, even if corporate philanthropy involved material sums, deference would still be appropriate. The theory of the second best holds that inefficiencies in one part of the system should be tolerated if “fixing” them would create even greater inefficiencies elsewhere in the system as a whole. Even if we concede arguendo the case against board control over corporate giving, judicial oversight or regulatory intervention still would be inappropriate if it imposes costs in other parts of the corporate governance system. By restricting the board’s authority in this context, the various academic proposals to “reform” corporate philanthropy impose just such costs by also restricting the board’s authority with respect to the everyday decisions upon which shareholder wealth principally depends. Slippery slope arguments are usually the last resort of those with no better argument, but one nonetheless must beware eviscerating exceptions that could swallow the general rule of deference. Once regulation of corporate philanthropy allows the camel’s nose in the tent, it becomes harder to justify resistance to further encroachments on board discretion.